US jobs, high yield covenant-lite issues and the Greek restructuring negotiation

Two topics are dominating the news of late: the decline in energy prices and the upheaval in Greek sovereign debt due to the upcoming general election. On the first issue, I have been generally positive about the economic impact because global energy importers need the economic relief lower energy costs provide. However, the decline is now becoming a market problem, particularly in high yield bonds, where covenants have favoured issuers, On the Greek issue, while I believe Greece will eventually exit the eurozone, I am not convinced, this will happen now. Instead I believe the ‘Olli Rehn plan’ of to reduce Greece’s debt burden by lowering interest rates and extending maturities is a compromise which is politically feasible. Thoughts below

Before I go into these two issues. Let me note that we just got US jobs numbers at 830AM ET and the numbers were stellar. Non-Farm payrolls were +252,000 for December 2014 and the unemployment rate came in at 5.6%. Consensus was +240,000 and 5.7%. Moreover, November was revised way up to +353,000. This report supports my contention that we are now in a 250-350k jobs numbers channel, up from 200-300k. I made the upward guidance in July because of what I saw on the jobless claims front. I believe the numbers are now only becoming apparent to the Fed and that the prospect of a rate hike in June has increased markedly.

Last January I noted that, “High yield and leveraged loan deals were issued in record amounts last year and the terms of those deals are increasingly lax. We see a move to payment-in-kind debt terms and light covenant restrictions as well as an increase in deal leverage. Average debt to EBITDA on leveraged loans in 2013 was 6.21, the highest since 2007 when the last crisis broke.” The laxity of covenant restrictions is now a problem for the high yield arena because of the problems that energy borrowers are now running into. Tracy Alloway and Ed Crooks at the FT noted yesterday that the lack of covenant restrictions allows debtors to take on new debt that could subordinate existing bondholders. They write:

Moody’s, one of the largest credit rating agencies, warned in research published on Thursday that many could find themselves locked out of the capital markets and simultaneously see their credit facilities reduced by their banks.

That would mean they would probably have to raise additional financing by obtaining “second lien” loans secured against their assets, effectively subordinating unsecured bondholders and making them more exposed to losses in the case of default.

“Their credit facilities are pretty much capped so they want to secure other debt. It’s going to be secured debt and it’s going to be second lien,” said Alexander Dill, Moody’s head of covenant research. “The unsecured bondholders are in jeopardy because of that.”

Subordination risk is heightened for energy bond investors since some oil and gas firms have been selling bonds that contain weaker investor protections – covenants – that do not necessarily restrict the companies from taking on additional debt.

The kicker here is that covenant-lite deals are rife in the high yield space. So, what occurs in the energy sector could be a harbinger of things to come more generally. To my mind, this particular issue speaks to the froth that had developed in risk assets as yield-starved investors took on risk in order to better returns. Only when the credit cycle turns down and the cycle-trough losses are recognized will we be able to fully account for whether those risks were worth it.

On oil, according to the Wall Street Journal, American oil and gas companies have taken on $200 billion in debt in the last four years, increasing their borrowing by 55% in that time frame. Many of the newer players are cash flow negative – burning through more cash than they earn in revenue. And with oil prices so low, this problem is only getting worse.

The toll is mounting now to the point where bankruptcies have started. This past Sunday WBH Energy filed for bankruptcy protection after it was cut off by its lender who refused to pony up more money, ostensibly because it felt it was throwing good money after bad. Some energy analysts are warning that many more defaults are coming. Daniel Katzenberg, an analyst at Robert W. Baird & Co. says plainly “There are too many ugly balance sheets.”

Now, let’s remember that the oil price you see quoted on TV isn’t remotely the same price that the shale oil guys are getting. Reuters noted on Wednesday that in January prices received by oil producers in North Dakota’s Williston Basin have averaged less than $34 per barrel – a figure a full $15 below where the American benchmark West Texas Intermediate crude oil is quoted. That means the cash flow situation is even worse than we think because these producers are $15 further below their breakeven levels than the benchmark prices suggest.

And, frankly, there is no relief in sight because oil prices should continue to be under pressure. In the short term, U.S. crude oil production has to keep rising for two simple reasons. First, according to Reuters, because shale drilling was increasing at such a frenetic pace in 2014, there were 650 wells waiting on completion services at the end of October 2014. This crude has yet to hit the market and will add to existing supply. Second, with so much debt riding on these oil wells, individual companies can simply not afford to cut back production. They have to service their debt with cash flow from the oil they sell or face default.

The bottom line here: We have seen the Boom. And now we are seeing the bust. But this bust still has a long way to run. There will be a lot of pain ahead, enough to make me worried whether the decline in price is still going to end up being a boon for consumers or a bust for the economy via a financial crisis. And note, investors are loading up on oil ETFs, even as the price of oil continues to drop. December was the biggest month for inflows into these funds in over 4 years.

On the Greek news front, the German government finally came out and repudiated the speculative Spiegel story that caused so much turmoil earlier in the week. The Spiegel article certainly does represent German thinking on the issue, at least directionally. But spelling out a Grexit scenario so early doesn’t do anyone any good because that is the worst of the four scenarios I outlined in December. There are at least two other scenarios without Grexit that are still viable.

The first scenario is one in which Syriza wins and Greece defaults but remains within the eurozone. Let’s call this the most confrontational scenario.I believe this option has a high likelihood of occurring if a negotiated agreement cannot be reached with the Troika. And despite the German Grexit talk in the Spiegel article, it’s not yet clear that Merkel and Schäuble are actually willing to move to Grexit under this scenario. I believe contagion would be manageable under this scenario given the ESM and ECB quantitative easing backstops.

The second scenario is one in which Syriza wins and Greece negotiates a restructuring. I’m calling this the ‘Olli Rehn’ scenario because Rehn is the first European politician to voice support for this outcome. What I’ve been hearing is that some Troika debt interest rates could go as low as 0%, depending on targets that Greece hits in terms of its Troika program. The point here would be to rule out principal reduction, in particular because it would mean a loss of capital at the ECB and there are still huge political issues around the ECB’s taking losses. Losses on existing debt would expose the ECB to criticism that it was reckless when it bought Greek bonds during the initial crisis wave. And principal losses would also raise the recapitalization issue in Germany because a weaker central bank capital base is unacceptable politically to large parts of the European establishment. As a result of these political issues, lengthening maturities and reducing interest rates is the likely negotiating area.

It’s still early days in Greece. We haven’t even had the general election yet. Two key dates going forward are 22 January when the ECB decides on quantitative easing and 25 January when the Greeks go to the polls. After these dates, we will have a better view on the options available and can start pegging odds. As it stands today, I see the Grexit talk as speculative and counter-productive. The potential for a negotiated agreement still exists. And even if no agreement is reached, I am not convinced the Germans would opt for Grexit or that they have the leverage to make it happen. We’ll just have to wait and see.

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